United States: Court Examines Application Of Implied Covenant, Step-Transaction Doctrines

While the decision by Delaware Court of Chancery Vice Chancellor John W. Noble in Ellis v. OTLP GP LLC, C.A. No. 10495-VCN (Let. Op. Jan. 30, 2015), takes as its form a letter opinion addressing the merits of a motion to expedite, the court's discussion of the merits of the dispute (in applying the "colorable claim" aspect of the test for expedition) is worth noting for its coverage of two topics. First, does the implied covenant of good faith and fair dealing preclude structuring a transaction (in a manner specifically permitted by the governance documents) to avoid having to submit the matter to a vote of unaffiliated unitholders? Second, should a transaction's two phases be deemed a unitary transaction under the "step-transaction doctrine" such that a vote of unaffiliated unitholders was required to approve it? The court answered both questions in the negative and refused to expedite the proceedings seeking to enjoin the vote on the proposed transaction.

The Transactions

The plaintiffs are limited partners of Oiltanking Partners L.P. Oiltanking's general partner was OTLP GP LLC (the GP). The GP was wholly owned by defendant Marquard & Bahls AG (M&B), which also owned 65 percent of the limited partner units in Oiltanking. In June 2014, defendant Enterprise Products Partners L.P. approached M&B regarding a purchase of Oiltanking, which would include a purchase of both M&B's 65 percent interest as well as the 35 percent owned by unaffiliated limited partners. M&B was willing to entertain a transaction with Enterprise, but was only willing to do so if it could be structured to avoid a vote that would depend on the support of the unaffiliated limited partners. Pursuant to Oiltanking's LP agreement, any merger would require the affirmative vote of a "unit majority." Given the definition of unit majority in the LP agreement, the affirmative vote required to approve a merger would depend on when that vote was taken. If taken during the "subordination period," the vote required for approval would be at least a majority of the limited partner units not affiliated with the GP—which acted as the functional equivalent of a "majority of the minority" condition to approval. If the vote was taken after the subordination period, then approval by a majority of all limited partner unitholders was required. The subordination period was based on the period pursuant to which the unitholders were to receive certain cash distributions and was expected to end in mid-November 2014.

Given M&B's preference for a transaction that would not require a majority vote by the unaffiliated unitholders, M&B and Enterprise agreed to a deal structure where Enterprise would acquire the limited partner units owned by M&B (representing 65 percent) and announced that Enterprise would complete a merger for the other 35 percent after the expiration of the subordination period, which would expire approximately six weeks later. Thus, as structured, the transaction was specifically designed to avoid the need to solicit the affirmative vote of the unaffiliated unitholders during the subordination period, and would allow Enterprise to approve the merger solely with the 65 percent of the votes it would then own.

The plaintiffs sued to enjoin the vote on the merger and asked the court to rule that the merger could only be approved by the affirmative vote of a majority of the unaffiliated limited partners. In support of that argument, the plaintiffs contended that "because the acquisition was announced during the subordination period, the voting standard applicable during the subordination period would govern the merger vote." The plaintiffs asserted two theories. First, that the LP agreement was ambiguous on this issue, and thus the court should apply the implied covenant to find that a transaction announced during the subordination period but voted on after its expiration is nonetheless subject to the vote that would be required during the subordination period. The plaintiffs also argued that while each phase of the transaction might be valid if viewed in isolation, they were—in reality—a single, unitary transaction that was subject to the vote that would be required during the subordination period.

The Implied Covenant of Good Faith and Fair Dealing

The court declined to find that the LP agreement was ambiguous such that terms should be implied. The court noted that the "LP agreement specifies a voting standard during the subordination period and a voting standard for after the subordination period. ... The plaintiffs offer no reason why, under either the LP agreement or Delaware law, the voting standard is not determined by reference to the time of the vote"—as opposed to the announcement of the transaction. The court, therefore, found that there was no omission from the LP agreement warranting the application of the implied covenant of good faith and fair dealing. Moreover, the court cautioned that "the implied covenant is not a free-floating duty that requires good-faith conduct in some subjectively appropriate sense ... [but] rather, the doctrine by which Delaware law cautiously supplies implied terms to fill gaps in the express provisions of an agreement." Given the subordination period was "well-defined and its expiration was readily predicted," the court found that holding the limited partners to the voting scheme to which they agreed in the LP agreement would not be inequitable.

The Step-Transaction Doctrine

The plaintiffs' second argument contended "that the entire process by which M&B sold its interests to Enterprise and Enterprise pursued a merger must be assessed as a single integrated transaction"—and hence, would be subject to the vote required at the time of the first part of the transaction. The court also rejected this theory. M&B, as a holder of 65 percent of the limited partner units, was well within its rights to steer Enterprise toward a purchase of its 65 percent. The court then found that Enterprise, as the now-holder of 65 percent of the limited partner units, was free to work within the confines of the LP agreement, await the expiration of the subordination period, and then complete the merger transaction upon the force of its 65 percent vote. The court found that these two steps were distinct, and that the step-transaction doctrine's "end result test, the independence test, and the binding commitment test" were not satisfied.

While the letter opinion addresses a couple of other theories raised by the plaintiffs, the court's discussion of the implied covenant and the step-transaction doctrine are likely the topics for which this opinion might be consulted going forward.

Previously published by Delaware Business Court Insider

Richard L. Renck is a partner in Duane Morris' Wilmington office. His practice focuses on complex corporate and commercial litigation, including actions relating to the Delaware General Corporation Law and common-law fiduciary duties, as well as advising corporate boards, directors and committees of boards in high-stakes litigation and counseling directors and senior executives regarding issues of corporate governance.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.

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